Friday, August 09, 2013

There are real-world consequences to over-issuing credit and currency.

Creating credit is the same as printing money when interest rates are zero. If I borrow $1 billion at 0% from the Federal Reserve (because I'm a Too Big to Fail bank, for example), it is functionally equivalent to printing $1 billion in cash currency because the credit costs nothing.

Let's say there is a .25% interest rate cost and printing cash also costs .25%. The carrying costs of both are trivial.

As a result, those with access to cheap credit have the equivalent of a printing press. I illustrated this recently with an example of three traders entering a trading fair: Trader 1 only has cash that has been earned and saved; Trader 2 has access to leveraged credit (i.e. borrowing $100 based on $10 of cash collateral) and Trader 3 has a printing press that creates cash currency. The Financial System Doesn't Just Enable Theft, It Is Theft (July 31, 2013)

As a result, Traders 2 and 3 could buy a lot more real-world goods at the fair than Trader 1, enabling the two traders with essentially unlimited credit/cash to reap enormous profits on carry-trades and other speculative trading.

Not only can trader 2 and 3 purchase more goods than trader 1. Trader 2 and 3 have no limit on what they can bid and therefore can price trader 1 out of the market completely. This can and does lead to economic warfare and control over states that have to import the majority of their food and/or energy.

This is a profound insight. Let's take two states, both of which issue credit and currency. The first is the U.S., and the second is a beleaguered state (State 2) with too much public and private debt and little collateral (for example, gold reserves) to back its currency.

The second state can issue as much currency and credit as it chooses, but the value of that capital falls in direct proportion to the quantity issued. Those sellers who accept this credit or cash as payment for real-world goods have little trust that the money issued by State 2 will retain its current purchasing power in the future. As a result, there is a huge risk premium priced into the trade, and relatively few traders will accept the risk of trading a potentially worthless currency for their scarce resources.

For whatever reason (and there are more than one), the trader trusts that the U.S. dollar will retain its purchasing power long enough for the trader to trade it for some other asset or form of capital, or even hold it as collateral for future loans.

Harun's point is the U.S. can outbid State 2 for oil or any other resource because it's essentially free for the U.S. to issue credit and cash. The price for the resources in U.S. dollars will soar in a bidding war, and while the U.S. can simply issue more credit/cash, State 2 is rapidly impoverished as the cost of essential resources rises.

Eventually this leads to a bidding war for trust: Whose credit/cash will be trusted to retain its purchasing power? There is a grand irony here, of course; as issuers of credit/cash attempt to debase their currency to boost their exports, their debased currency buys fewer real-world resources.

In a global credit crisis created by the over-issuance of credit/debt, which currencies will lose trust and which will gain trust? Those which retain or gain trust will enrich the issuer and those who lose trust will impoverish the issuer.

Nations that lose this bidding war for trust may reckon it's "cheaper" to wrest control of the needed resources by force rather than go through the arduous steps necessary to rebuild lost trust in their credit and currency.

In sum: there are real-world consequences to over-issuing credit and currency.

Things are falling apart--that is obvious. But why are they falling apart? The reasons are complex and global. Our economy and society have structural problems that cannot be solved by adding debt to debt. We are becoming poorer, not just from financial over-reach, but from fundamental forces that are not easy to identify or understand. We will cover the five core reasons why things are falling apart:

Complex systems weakened by diminishing returns collapse under their own weight and are replaced by systems that are simpler, faster and affordable. If we cling to the old ways, our system will disintegrate. If we want sustainable prosperity rather than collapse, we must embrace a new model that is Decentralized, Adaptive, Transparent and Accountable (DATA).

We are not powerless. Not accepting responsibility and being powerless are two sides of the same coin: once we accept responsibility, we become powerful.

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